SEC probe highlights risky Wall Street dealmaking

NEW YORK 
A murky financial product created and sold by Goldman Sachs helped a Wall Street hedge fund pocket huge profits from the housing crash at the expense of unwitting investors, the Securities and Exchange Commission has alleged.

The SEC's probe of the product called ABACUS 2007-AC1 sheds light on the shadowy securities and high-stakes dealmaking that helped pump up the housing bubble and nearly toppled the financial system when the mortgage market crashed in 2008.

The ABACUS product was what's known as a synthetic collateralized debt obligation, or CDO. A CDO is a pool of securities, tied to home mortgages or other types of debt, that Wall Street firms packaged and sold to investors at the height of the housing boom.

Buyers of CDOs, mostly banks, pension funds and other big investors, made money off the products if the underlying debt was paid off. But as U.S. homeowners started falling behind on their mortgages and defaulted in droves in 2007, CDO buyers lost billions.

In the case, the SEC alleges that Goldman defrauded investors who bought the ABACUS investment in early 2007 by not fully disclosing what they were buying. The agency says Goldman and a then 28-year-old employee, Fabrice Tourre, stuffed the CDO with mortgage-backed securities that were riskier than they appeared. They then sold the product to investors for a large commission, the SEC said.

CDO deals like ABACUS earned banks tens of millions in fees during the housing boom, and investment bankers were under pressure to package and sell the products quickly, said Nomi Prins, a former Goldman Sachs employee.

"Within the idea of packaging things that are risky to begin with is the notion of moving that risk along," said Prins, author of "It Takes a Pillage: Behind the Bonuses, Bailouts, and Backroom Deals from Washington to Wall Street."

Goldman told investors that a third party, ACA Management LLC, had selected the pools of subprime mortgages it used to create the CDO. What Goldman didn't disclose, according to the SEC, is that New York hedge fund Paulson & Co. "played a significant role" in picking the securities that went into the product.

Paulson & Co. is led by John Paulson, a respected money manager who made billions betting that the housing bubble was about to pop. After helping select the securities, Paulson & Co. then placed bets against them by buying credit default swaps, a form of insurance that pays out if the underlying asset goes into default, according to the SEC.

Goldman denied any wrongdoing and said it ultimately lost $90 million on the transaction. Paulson & Co., which wasn't charged in the SEC complaint, said it wasn't involved in marketing the CDO and "made no misrepresentations."

"Obviously, the SEC didn't think it had the legal grounds to sue Mr. Paulson and his hedge fund," said Jeffrey Plotkin, a lawyer and former SEC official in charge of broker-dealer enforcement.

The SEC said Tourre knew about Paulson's bets against the CDO but led ACA Management to believe that the hedge fund had in fact made a roughly $200 million bet that the investment would rise in value. Only three months before the deal was completed, Tourre wrote an e-mail to a friend suggesting he knew the mortgage market was heading for disaster.

"More and more leverage in the system, The whole building is about to collapse anytime now," Tourre wrote, according to the SEC. "Only potential survivor, (Tourre) ... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!"

For Goldman's services, Paulson paid the bank about $15 million, according to the SEC. By January 2008, nine months after the CDO deal was completed, 99 percent of the securities in the CDO had been downgraded, the SEC said.

Investors who had bought the CDO lost more than $1 billion on the bet, while Paulson's bets against the product earned the fund nearly an equal amount in profit, according to the SEC.

The biggest loser on the bet was ABN Amro, a major Dutch bank, which paid Goldman $841 million, the SEC said. Another investor, German commercial bank IKB Deutsche Industriebank AG, lost almost its entire $150 million investment. Most of the money went to Paulson to settle credit default swap transactions between Goldman and the hedge fund, the SEC said.

Bill Fleckenstein, a Seattle-based hedge fund manager who predicted the housing crisis, said investors often bought and sold risky investments during the housing boom without fully understanding them. Still, he said proving that Goldman committed fraud by selling the product may not be easy.

"At the end of the day, these weren't deals being peddled to mom-and-pop investors," Fleckenstein said. "These were transactions between sophisticated buyers and sellers"

There may have been fraud," he added, "but it's also true that the buyers didn't do their homework."

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AP Business Writers Marcy Gordon and Alan Zibel in Washington contributed to this report.